Market discipline and financial stability

1. Market discipline and financial stability Glenn Hoggarth Patricia Jackson Erlend Nier

2. Effective market discipline • Market must have information to assess riskiness • Market participants must be at risk of loss • The cost to a bank of an adverse market view must be significant

3. Equity price - cost and availability of capital - takeover target Channels for market discipline • Affected by • shareholders limited liability • - gambling for resurrection • expectations of support • sub-contract monitoring to regulators

4. Bank counterparties • cost and availability of funding • access to swap and derivative contacts • graduated reaction more likely from wholesale counterparties • Affected by • deposit protection arrangements • too big to fail

5. Subordinated debt Accounts for around 3% of total liabilities of UK banks • but does give the banks added flexibility re capital Affected by • expectations of support

6. Main channels for a graduated response • Equity price • Bank counterparties

7. What is the effect of transparency?Does it make market discipline more effective? Bank of England research tested the effect of disclosure “Market Discipline, Disclosure and Moral Hazard in Banking” (Nier and Baumann)

8. Cross country panel data set • 729 individual banks from 32 countries • typically observations from 1993 to 2000

9. Identified measures of the strength of market discipline

10. Depositor protection Index on existence and extent Depins 2 = 1 or 0 - if schemes exist Depins 3 = 1 or 0 - no co-insurance Depins 4 = 1 or 0 - interbank deposits covered Depins 5 = 1 or 0 - unlimited coverage Depins = sum of depins 2, depins 3, depins 4, depins 5

11. Fitch Government support

12. Disclosure Constructed an index on core disclosure items from BankScope 18 categories covering following areas -

13. US listingNYSE, NASDAC or AMEX

15. Some MKD variables may be endogenous Instrumental variables Two Stage Least Squares procedure

16. Results Deposit insurance and support have a negative effect on capital US listing and disclosure index have a positive effect on capital Tested if existence or not of a rating was significant - it was not

17. Implications for public policy

18. Limit safety nets/deposit protection schemes • Where substantial - more onus on supervisors • Encourage greater disclosure - voluntary disclosure seems limited in good times

19. Nature of disclosure - comparable disclosure important VaR

21. Over time risk asset ratio became less comparable - by March 1998 non-mortgage securitisation10 largest US bank holding companies $200 billion - equivalent to 25% of risk-weighted loans

22. Basel II will create new common language • PD • LGD • EAD Must meet set standards

23. Pillar III • Banks resisting comparable disclosure but it is essential • loans by PD band • default outturns • information on LGD

24. Use of market prices in supervision Do market prices reflect the riskiness of a bank?

25. 7 major UK banks Bond spreads Real equity prices Implied volatilities Implied PDs

26. Relationship between each market indicator and banks’ accounting ratios

27. Panel regressions for the eight UK banking groups - 1995H1 to 2002H2 Tested leading indicator properties - Test is whether Current properties -

28. All market measures reflected one or more of the current balance sheet measures of risk but no evidence of leading indicator properties (over and above information from lagged balance sheet measures)

29. Event study • Week of 16 known adverse events • 4 market indicators moved right direction - 75%-83% of the time • Implied volatilities best reflectors of risk

30. But market indicators noisy • Type II errors quite large • 20% large moves could not be explained

31. Given importance of counterparties • volume/price indicators of exposures might be important